Jacoby’s The Milk Check Podcast … Cauition: Optimism Ahead

Below is a transcript of the podcast. If you would like to hear the audio or learn more, Please go to: https://www.jacoby.com/caution-optimism-ahead/

So far, milk production across the eastern U.S. is trending downward. Cheese prices are strengthening. The pieces are in place for an industry-wide recovery. Will it happen?

Also, Ted, T3 and Anna answer some questions submitted by a listener.

Anna: Welcome to “The Milk Check,” a podcast from TC Jacoby and Company where we share market insights and analysis with dairy farmers in mind. We’ve seen an increase in the cheese price and the Class III price is looking up for March. Do either of you think that’s sustainable, and has that changed your forecast for the end of the year?

T3: It looks like the Class III price in December and January are both gonna be somewhere right around $13.96, $13.95. You’re probably gonna have two months in a row where your Class III price is within 10 cents of each other. Last couple of weeks we’ve seen a bit of a pop in the cheese market. So we’ve seen the cheese market go from…

 

 

Ted: Why did we see the pop?

T3: A couple of factors. One, I think December and January were pretty good months for export orders. Mostly…not necessarily a traditional market like Mexico. More, you know, Asia, the Middle East. I think we saw a pickup in demand for U.S. cheese in those markets because, one, Europe’s milk production continues to struggle and the U.S. cheese market in December and January was lower than the world price. I should qualify, the spot market was lower than the world price, but the futures market was actually higher than the world price. So you saw a lot of spot buying that was going into the international markets, but that kind of kept the U.S. cheese market cleaned up a little bit.

And I think what happened is we got into February, that started to become a little bit more apparent to the buy side of the equation domestically. Now there’s a warning embedded in this as we’ve gotten into a price and the $1.50s for blocks and the $1.40s for barrels, we’ve taken ourselves out of the international market. And so we’ve lost a nice chunk of demand that we were getting 15 cents ago when we were in the $1.30s.

Ted: But the futures market hasn’t really changed that much.

T3: No, it hasn’t. And we’ve had a lot of discussions about that in our office as to why. And I have two beliefs about that. The first is I don’t think that our cheese markets are ready for a big rally. I do think they’re coming back, in other words, I don’t think a $1.58, $1.59 block price is sustainable in the middle of February. I don’t think a $1.42, $1.43 barrel price is sustainable in the middle of February. And so I suspect that sometime in the next three to four weeks, we may be up here for a few weeks, but at some point in the next three to four weeks, I expect those prices will come back down.

However, I’m also gonna say it this way, bull markets aren’t straight linear lines that go from a low price to a high price. They evolve over time and they evolve within volatility. And usually the way it works is you start out with a really low price, you go to a higher price, then you’ll pull back to another low price. But that low price is a higher low and then you ended up with a higher high and then a higher low. And so the market’s still cycling from high prices to low prices, but every low price is a little bit higher than the last low price and every high price is a little bit higher than the last high price.

And so the way I expect that this cheese market’s probably gonna play out over the next, let’s call it 12 to 24 months, is we’re still going to see volatility. You know, maybe we peak this cycle around $1.59 in blocks and maybe $1.42 in barrels. And then we pull back maybe to $1.45 in blocks and $1.32 in barrels, which is…maybe even $1.25 in barrels. That’s still higher than the low a month ago. And then the next cycle through, which maybe happens in late March, early April, just before Easter, Easter is late this year, maybe you go a little bit higher, maybe the blocks get up into the $1.60s for a couple of weeks and maybe the barrels get up into the high $1.40s and then you go back down. And so you have these series of higher highs and higher lows, but it takes a long time for those prices to get to a point where they’re translating to $17 or $18 Class III prices.

Ted: I’m gonna take a little bit more aggressive tack than that. I think that, you know, what you said is correct about the cheese market being more stable, but I think the prices this fall are gonna be higher than the $16, $17 range. You’re only looking at 10 cents or so a pound of cheese from where we are right now, that’s not enough. I would say, you know, 20 or 30 cents a pound cheese would put the Class III price up in the $18, $19 range this fall. Now, I don’t think it’s gonna be an explosion. I think it’s gonna be very steady. The inventories are gonna keep it steady, but it’s gonna get up a lot higher than just $17. You know, I think we’ll be bumping $1.90 before it’s over, somewhere in that area. And the $19 milk for the dairyman will look a lot better to them when we get to November than what he’s got right now.

 

 

T3: When I think purely about cheese price and I think about the second half of 2019, it is actually pretty easy for me to imagine cheddar blocks, 40-pound blocks, pricing themselves at $1.90 in October and November.

Ted: You’re worried about barrels?

T3: I’m worried about barrels. I don’t believe barrels have the same capability. Here’s why. First, keep in mind that processed cheese demand in this country last year was down, I think the final number was about 4%, 4.5%, but there were months where it was down 6%. Those are big numbers. That equates to demand for barrels.

Ted: But the natural cheese…

T3: Is up.

Ted: Significantly.

T3: Yeah.

Ted: A little more than normal.

T3: I agree.

Ted: And so it offsets somewhat the loss  of processed cheese. Processed cheese basically is only like 40% or 50% cheese anyway.

T3: It only offsets it if there’s capacity for it to move, and that’s my concern. You have a number of cheese plants out there that are barrel plants. They make barrels, they only make barrels.

Ted: But they only make it when they got the milk and they’re not gonna reach out and buy milk just to run. A block plant will. So if the block is a premium and it’s running okay and if there’s a choice between barrels and blocks, they’re gonna run blocks in a short market.

T3: I don’t necessarily agree, for this reason. What is driving barrel production in this country is not actually barrels. It’s whey. People want whey from white cheese. And they prefer whey from white cheddar over whey from white mozzarella, though they’ll take the mozz as well. You had added barrel capacity two years ago and three years ago not because there was this huge outstanding demand for barrels. It was because there was this demand for white whey. And so they’re making those barrels because of the white whey. And the conversations I have with these barrel manufacturers, when we talked about the barrel market and what their options are, the conversations more or less go like this.

“I need the whey to be white. What other cheese can I make and still have white whey? Because I’m not gonna make colored cheddar blocks because that’s not white whey, that’s colored whey.” So they look into things like white cheddar, which works if we’re priced right into the export market. That’s a struggle as you talk about cheese prices in the U.S. getting higher, you start talking about cheese prices in the U.S. at a $1.70 and $1.80. You know, we don’t know what the rest of the world is going to do, but I think let’s make an assumption that once we get into the $1.80 range in blocks, we’re probably gonna be priced out of the international market.

The other possibility is they can make…the same plants that make 40-pound blocks or even barrels can also make parmesan. Ironically, the parmesan is on market in the U.S. right now has become saturated as well for the very same reason. And so you have an oversupply of barrels and you have an oversupply of industrial parm. And by industrial parm, what I mean is parm that ultimately gets graded. You buy the green shakers, that was originally industrial parm.

Ted: I would point out that one of the problems that we have with whey right now is that a lot of which, a good percentage of which goes to China is the swine fever…is that what they call it? The disease that’s really effective whey shipments into China.

T3: However, that is feed whey, which is the whey that’s made from colored cheddar.

Ted: No, most of that, it’s feed whey.

T3: It’s mostly whey permeate.

Ted: Well it is but, you know, there isn’t that much feed whey made. Most of them make human-grade whey and it winds up going to chickens, to poultry and swine in China in big percentages. So if they continue to have that problem, it could affect the whey market, which of course, will carry back to the barrel market.

T3: But not in the way that you think because when you talk about…I do agree with you. The swine fever issue, the African swine fever issue in China has the potential to be a very big problem for the whey market. But specifically that market, that’s not the market that cares whether the whey is white whey or not. The market that wants white whey is the market that uses whey protein isolate. It’s the protein side of the equation when they’re fractionating the whey into whey protein isolate and usually whey permeate or lactose. And a lot of that whey protein isolate goes to places like baby formula or high-end sports nutrition drinks and things like that. They’re the ones who want the white whey because they’re the ones who are willing to pay a premium for the white whey.

Ted: But if we’re seeing a 10% drop in production, okay, it’s gonna take the marginal return out of there. It’s gonna take the powder market, although the powder market’s been strong, but it’s going to take the barrel people out of the equation.

T3: Ten percent, I’m not gonna predict a 10% drop.

Ted: Okay. I’m not buying into it either.

Anna: Thanks for saying that.

Ted: I think that’s severe but that’s what we’ve heard. Not internationally, just in the Upper Midwest. That’s gonna change the dynamics of who’s producing what, and class one sales are continuing to decline, so that’ll offset someone.

T3: Let’s be clear, if we get milk production decreases in the Upper Midwest, anything approaching 10%, let’s just call it over 5%, look, all bets are off. We’re gonna see $2 cheese because that’s a drastic…milk is a very inelastic good.

Ted: Well, I was arguing with you that…

T3: You’ve got a lot of dairy farmers throughout the Upper Midwest that are cheering at the moment because you just said that might be down 10%.

Ted: I don’t think it’s gonna be down 10% either, but I do think it’s gonna be down significantly and then the marginal returns are gonna be out the window. The milk is gonna go to the highest return and you’re gonna look at the pay prices bumping up the equivalent of a $1.80, $1.90 cheese. Now, whey has a big effect on that. But we’ve got six months to let it play out. So I think the second half of this year could be quite strong. I don’t think an explosion is in the cards. I’d be very surprised if the Class III goes above 2 bucks, but I wouldn’t be surprised at $1.90.

T3: You mean the cheese price?

Ted: Cheese price.

T3: Let’s talk more realistic numbers. If we’re getting, you know, 6%, 7%, 8% reductions milk in the Upper Midwest, I’m gonna agree with everything you’ve said that barrels are in trouble, powder plants are in trouble. I mean milk is a very inelastic good and those are huge decreased numbers and that is going to cause a major seismic shift. I think more realistically, we talk about maybe a 2% to 3% decrease in milk in the Upper Midwest. There will be pockets that may be pushing 10%, but what I think is more likely is when you hear a number like 10% you may lose 10% of the farms in a certain region, but what percentage of those farms are gonna be the smaller farms? And so by losing 10% of the farms, you may only lose about 3% of the milk because it’s those highly efficient large farms or the ones who somehow manage to survive.

And at 3% what you’re gonna get is you’re going to lose milk into butter powder plants. So you’re gonna make Class IV prices better. You’re gonna lose milk into those marginal buyers of spot milk who can’t afford to pay up for that milk. And you’re right, if those are cheese plants, it’s the barrel plants who lose it. But out West, you’re not gonna lose 3%. You certainly not gonna lose 10%. New Mexico, Texas, Southern Kansas, Southern Colorado, I think your milk production is gonna be flat to higher. I think you’ll still be up 1%. You may not be adding any farms, but you’re gonna continue to have increases in milk production per cow. And so you’re gonna continue to have more milk in the region. And so you’re gonna see milk production growth there.

I think you’re gonna see milk production continue to grow in Idaho, albeit you’re talking flat to 1%, not that much. I think you’ll be flat to maybe a little bit higher in the Northwest, in Oregon and Washington. You could pretty much paint the whole half of the United States east of the Mississippi and just about every state’s probably gonna lose milk production over the course of this year. I think California is probably the wild card because if you see significant decreases in milk production in California, you could see prices take off. You could see powder prices take off, you could see butter prices take off, and then you’re gonna see cheese prices take off.

Ted: Well, we’ll see.

Anna: We’ve received a few questions over the past few weeks. Are we ready to move on to those?

Ted: What was the next question we had?

Anna: First, is use of beef on dairy breeding actually going to make a difference in cow numbers? In other words, are enough dairymen using it, using it enough, and will continue to use it if milk prices rise?

Ted: I think that that is a very perceptive question. A lot of the dairymen are breeding for beef instead of breading to bring out a heifer that’s gonna bring in the milk stream two years down the road. They’re breeding for beef because they don’t wanna spend the money to pay for bringing in the heifer online two years away. So one of the things that’s gonna impact our prognostications as to where this thing’s going, gonna be a shortage of good heifers. It’s gonna take a dairyman with one hell of a lot of equity just to stay with the crowd and bring his heifers online to replace the cows that are gonna go to slaughter in the normal cycle of things. So picture that we get to 2020, January 1st of 2020, and the market is out of the toilet and it starting to look good. Oh. Where are the replacement cows gonna come from? It takes two years to get the replacement online. So that’s a significant factor in the cycle of things, which takes us basically up through 2021 with a very positive projection as far as the upslope in pricing is concerned.

T3: And let me add to that. First, as we were just talking about before, dairy’s a pretty inelastic good. If you just take, let’s call it, 5% of calves are bred for beef rather than bread for dairy, 5% is a small number. That’s 1 in 20. That’s a big number two years from now because a 5% move is a big move.

Ted: A lot more than 5%.

T3: Well, and I agree with you. I think it could be a lot more than 5%. So how does that play out? First, let me answer a question this way. Why do we think it’s gonna be at least 5%? The way that I think this breeding for beef is happening, I think the larger dairy farms are doing it a lot more than the smaller dairy farms. And so if you’re talking about a dairy farm under 500 cows, I think it’s probably unlikely that they’re breeding for beef. Some of these 2,000, 3,000, 5,000-head dairies, I think they’re probably paying very close attention and they’re breeding as much as half their herd to beef and all they’re doing is keeping their best-performing cows and breeding those to dairy, but they’re not taking all of them.

Why are they doing it? It’s a simple question of economics. Margins are tight right now, so how can you save money? If you do not have to pay to raise your heifers and instead, that cow is calving and then you’re able to sell that calf and get some return for that calf, that’s probably gonna be much better for your pocketbook than keeping that calf and raising it. And so it’s a way for them to get income quickly rather than having to wait two to three years for it to become an income-producing dairy cow.

So these larger dairy farms…and keep in mind, 70% of our milk at this point comes from dairy farms of over 500 cows. It may only be, you know, 20% of all farms with over 500 cows, but it’s 70% of the milk. Those are the cows that are breeding. Those are the farms that are breeding to beef and I think that number could be quite significant. Even if it’s just 5% in two years, that’s a big number because 5% really moves the dial in dairy. It’s very likely that it’s closer to 10%. And if it’s closer to 10%, not only are you gonna see a shortage of milk 12 months from now, but the problem is just going to exacerbate itself as you get to 24 and 48 months from now. That is the hope at the end of the tunnel. So if you see a light at the end of the tunnel…

Ted: I think it’s very bright, at the end of the tunnel. You know, you’re looking January 1st, 2021, ’22 at the earliest before we see any risk of a downturn. And more than likely at that point in time things will just get back to normal “so to speak.” So you could be looking at a four or five years of extended gradual increases in price for where we are right now.

T3: You could. Now, the flip side of that is this, if dairy prices get high enough and if there isn’t enough heifers, what a dairy farmer can do is just not send that cow to slaughter, go ahead and cycle it through. I mean today, I think the average cow doesn’t even make it to three lactations. So let’s say prices get really high. How are they gonna react to that? They’re gonna keep that cow for another lactation. That’s the way they’re going to end up offsetting that. That’s not necessarily a problem, but it does require an adjustment when we get there.

Ted: Right. Okay. Next question.

Anna: I’ve read that regions outside of the Federal Milk Marketing Order System in California such as portions of Wyoming, Idaho, Montana, Utah, and Colorado were early innovators in establishing fat and protein differentials before it was added to the federal system. Is that true? And if so, are there maybe innovations coming from that region that could be implemented federally?

Ted: I’m not sure why the geography of that is particularly significant. The federal order’s been implementing component pricing now for basically 20 years.

T3: It’s been longer than that.

Ted: Yeah, it has. There are still a couple orders out there that are on skim and butterfat. They don’t have any compulsion to go to component pricing because it’s essentially fluid, or tries to be. But…

T3: And I think it’s important to point out that that’s really the genesis of component pricing is for cheesemakers specifically, and for Class IV to a lesser extent, the value of the components was what was important, not the quantity of the milk. Whereas for fluid milk, when you’re bottling it and selling it in gallons…

Ted: They standardize it.

T3: Well, they standardize it, but there really isn’t any incentive to maximize your components. It’s the background behind the whole Jersey cow versus Holstein cow argument.

Ted: Well, there’s a lot of dairymen that seem to be moving towards Jerseys and we, in certain situations, are able to get premiums for Jersey milk depending on what kind of cheese it’s going into. And this has been going on for three or four years now in certain areas around the country. So I think the components are here to stay and I think there’ll be more important as we go along.

T3: What about…I think the real question that a man is asking is innovations. What do you think the next innovations are that are coming down and do you think that they’re likely to come from non-Federal Order parts of the country? The first thing I’ll say is in today’s day and age, I’m not sure there’s any distinct advantage when it comes to innovations in non-federal order regions of the country. Idaho is the region that comes to mind, I think easiest because that’s where there’s more milk outside the Federal Order than anywhere else. The reason though that I don’t think it matters much anymore is because even though Idaho is not in a Federal Order, the way the milk in Idaho is priced is still very much influenced by the Federal Order. And the way that those plants, cheese plants, powder plants in Idaho sell their products, their competitors are getting their milk in the federal order, and so it all kind of bleeds down anyway.

And so I think the federal order still has a significant effect in every region of the country, even those regions that technically don’t have a Federal Order. I think that is a little bit of a different question than whether or not we think that if the Federal Order were to disappear, could that spur a series of innovations that could make the dairy industry healthier? You can’t be blind to the fact that if we were to get rid of the Federal Order, there would be a period of upheaval first because there’s so many parts of our industry, the structure is built around the existence of a Federal Order. And the chaos from pulling it away would be very upsetting to the industry because of that. And so if we were to do something like get rid of the Federal Order, it would have to be something that happened over a relatively lengthy period of time. But I think if we did get to a place where we were not looking through the lens of the federal order system to figure out how to innovate for our industry, I do think we would be healthier in the long run.

Ted: I think the derivation of this gentleman’s question is he thinks that the non-regulated areas have fostered innovation more than the regulated areas. Well, I don’t know whether that’s true or not. I haven’t really looked at it that way, but we all have skepticism of the regulatory system. But as we’ve dealt with in times past, we basically have the regulatory system and then in addition, as a result of it, we have the classified pricing system. The classified pricing system does give us the ability to buffer the juxtaposition between the butter powder return and the cheese return whether one is good or one is bad versus the other. To some extent, not entirely, but to some extent, it levels out in the producer’s settlement fund.

T3: But I would argue that that buffer is a double-edged sword.

Ted: I would agree with you, the fact that it’s a double-edged sword because if you didn’t have the buffer, it would cause the processing plants to stay on the balls of their feet a little bit more. It also would require them to invest in alternative facilities if they’re gonna keep their milk supply and if they’re gonna remain solvent. They’re gonna need to have butter powder and cheese. They can’t just choose one or the other and go merrily down the road. So what did we cost out an average size cheese plant here a year or two ago, which is totally out the window now, $350 million?

T3: There’s the one being built in Michigan, I heard was gonna cost almost $500 million.

Ted: Five hundred and fifty million, okay, which includes all sorts of fancy whey-handling facilities. So if you didn’t have the Federal Order up there, what is it gonna do? Well, all of a sudden, all the milk comes out of that plant and goes down the road 20 miles to a butter powder plant.

T3: Well, I think it’s fair to say…

Ted: I got to figure out how that’s gonna work for the guys who are running the cheese plant. So yeah, it’s easy to say that the regulatory system fosters some inertia with regard to innovation. You’re probably right to some extent, but it also fosters a little bit of a comfort zone with regard to where you’re going and how you’re gonna invest your money.

T3: Right. But what’s the famous phrase, desperation and innovation are often good bed partners?

Ted: When you’re talking $200 million or $300 million, I don’t know whether it’s a bed partner that I wanna have. Get a little frosty. But by the same token, you know, I do agree that the regulatory system has become arthritic.

T3: That’s probably a good word for it.

Ted: Well, it’s as close as I could get on the spur of the moment, but it needs work. It needs to be either brought up to speed or gotten rid of and it may just happen automatically because of Class I sales are continuing to decline and it’s all based on Class I sales, the regulatory part of it. Cold turkey, I don’t see any other way to do it, frankly. You say over a period of time, how are you gonna buffer the classified pricing system over a period of time?

T3: First thing I’d do is I’d take the Class I market and the Class II market, I’d…you know, just like we’re moving towards a Class I price where the base is now an average of Class IV and Class III, so let’s make that base for both Class I and Class II. That’s what we’ll do first. Second, let’s get rid of all the zones, make the zones disappear. Why do we need zones in today’s day and age? We really don’t. Logistics costs will define what the costs are at all of those plants. You don’t need zones to define it. That’s the second thing I’d do.

*Note: Zones also determine the Class I price, which is subject to minimum price considerations under the Federal Order. The zones are structured such that the price of Class I milk increases as you move south and east; they increase the cost of balancing in the Upper Midwest. We discussed minimum pricing in greater detail in this episode of The Milk Check.

Ted: The zoning is supposedly to allow the movement to offset or defer the cost of movement of milk for Class I purposes from one area to another.

T3: Why is that important?

Ted: It’s not anymore, because…

T3: Thank you!

Ted: …because—when they set it up, it was an issue that they tried to address.

T3: I get that they set it up.

Ted: It works if the supply dynamic changes and suddenly you’re producing more milk, for example, in Georgia than you were producing in 2000. Now you’re moving milk against the zoning up north.

T3: And they’re gonna lose money on that milk.

Ted: You’re getting hammered. Not only are you paying to get it hauled up there, but you’re also getting hammered on the zone.

T3: Yes, but if you were to sell that milk in a free market, you’d be getting hammered also because it costs more for a dairy farmer to produce milk in Georgia than it does for him to produce milk in Michigan because of the climate.

Ted: Probably.

T3: But if it didn’t, then the market’s telling you it’s okay.

Anna: As the person filling out your federal order reports, I’m cringing at the idea of no zones.

T3: Zones probably make it easier. I don’t disagree with that. But you know, one of the most important functions of a market is often to send the difficult signal. A great example is what’s going on in the dairy industry right now. Milk prices are low and farmers are going out of business. So the reality is why are milk prices low? Because we have too much milk. Relative to demand, we have too much milk. So the market is sending the difficult signal, we’ve got to reduce our milk supply, and it’s happening and it’s painful, but it’s happening. And to a great extent, you’ve got the same issue with zones is without the zones you may have more volatility, you may have more challenges, but you are also going to send a clear signal to the buyers of milk, let’s say, in the Southeast as to exactly what their milk cost should be.

Ted: Another thought for another day.

Anna: Thank you to everyone who has sent us questions and comments. Keep them coming and we’ll try and address them in future discussions. We welcome your participation in The Milk Check. If you have comments to share or questions you want answered, send an email to [email protected] Our theme music is composed and performed by Phil Keaggy. The Milk Check is a production of T.C. Jacoby & Co.

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